Black Gold: Sell In May And Rue The Day

| About: The United (USO)

Summary

The recent Doha meeting between OPEC and Russia intended to freeze oil production ended with no agreement.

That freeze is happening anyway because their production has peaked at near-record highs, and any increase requires large investments that they cannot afford while oil prices remain low.

The gap between supply and demand is closing faster than most expected, due to production falling at some producing countries while demand continues to increase at a healthy pace.

The end result is continued rising prices.

The old adage "Sell in May and go away, don't come back till St Leger Day" - a British horse race held in September - has long provoked discussion on whether or not this is good advice, but some believe in it and, no doubt, it will soon be a topic again on SA and CNBC and Bloomberg TV programmes. I have little to offer to that discussion, but believe it will not be a good policy for oil investors to apply in 2016.

When my article "Light At The End Of The Oil Price Tunnel" was published on February 11, and a sequel on March 29, I foresaw a price increase, but did not expect one of nearly 70% for WTI by April 23. In the first article, I focused on supply and demand, and in the sequel, on some of the issues facing the main supply countries. Those issues and the links in the articles remain valid. Today, I will expand on some of those issues because more light is being shed on them - on an almost daily basis - that suggests constraints on supply while demand moves inexorably higher. As before, I will endeavour to join numerous diversely reported dots into a complete picture. The dots come mainly from articles and discussions - too numerous to link all - on SA, in the Financial Times and on CNBC, CNN, BBC and Bloomberg TV programmes.

Taking supply and Venezuela first. Venezuela has the world's largest oil reserves. Its production is thought to have been in decline at around 70,000 barrels per day for some time, but I can find no reliable information. What we do know is that this oil-rich country has started to import crude from the country it most loves to hate - the US - and many more millions of barrels are scheduled for delivery this year from the US. Dangerously low levels of water at its Guri dam, which produces more than one-third of the country's electricity (hydro power), may force it to close to avoid turbine damage. That could hit oil producers, who need electrical power and force redirection of oil exports to electrical power generators for general needs in the country. Recently, this Shock Exchange article brought news that Schlumberger (NYSE:SLB), Baker Hughes (NYSE:BHI), Halliburton (NYSE:HAL) and Weatherford (NYSE:WFT) are owed huge sums of money that might never get paid, so they are cutting back on services that are essential to stop oil production from slumping. Maybe Venezuela will soon be unable to pay for those oil imports as well. There is no world body or country available to rescue the country anymore, as it has exhausted all sources of aid, leaving it needing around $140 per barrel to balance spending. I am expecting a price increase, but do not see that ever happening so, presumably, this country will collapse, and with it its oil production.

Russia depends on oil and gas for 50% of its budget needs. Following the failed Doha meeting, we heard threatening words that output could be raised rapidly if it chose to do so, but Russia's largest oil producer, state-controlled Rosneft (OTC:RNFTF), has a mountain of debt, and its net income is worsening, down around 55% in the last quarter. At the same time, the company is having to increase investments just to maintain production levels because of declining output at its large Siberian oil fields; despite a 30% increase in drilling activity there, oil production fell by 1% last year. An additional increase in investment is planned this year to stop further production declines. Given that the Kremlin recently passed an order requiring Rosneft to increase dividends to 50% of net income, it means that a combination of these points makes it virtually impossible to afford sufficient investment to actually increase output without a significant oil price increase. I also doubt any oil company's CEO would risk the Kremlin's ire by increasing costs, and thus decreasing net income and that dividend.

Elsewhere, the political situation and other problems in Algeria, Libya and Nigeria are likely to prevent any increase in output from those countries in the foreseeable future. Summer maintenance in the North Sea could reduce supplies from June to September. Saudi Arabia - the causer of much of the chaos since mid 2014 - is borrowing money for the first time in 25 years and is unlikely to spend that on boosting production, thus lowering oil prices. US production is now down by around 200,000 b/d from last year. (Source: eia.gov)

Last week, the IEA predicted the biggest non-OPEC output fall in 25 years, while global demand growth is at a hectic pace, led by India, China and other emerging markets.

On the demand side, India is close to becoming the world's third-largest consumer of oil - displacing Japan from that position - and around 75% is imported. The country is now the world's sixth-largest car market, and its fleet is growing rapidly. China remains the number one consumer, and its consumption growth continues at a good pace, with car sales growing at 5-7% per year. In the US - number two in demand - the summer driving season starts soon, with consumption already up some 560,000 b/d in mid-March compared to the same time in 2015, according to the EIA. The EU is showing signs of life, and US crude is going to France, Italy, Germany and Holland, all of whom want to free themselves from dependence on Russian and Middle East producers. Israel - a country surrounded by oil producers that hate it - is starting to buy from the US, and Japan is also now buying from the US.

My oil and gas investment focus is primarily in the US. There are many good companies to choose from, and I hope readers will tell us about their favourites in comments on this article. My favourites include Cabot Oil and Gas (NYSE:COG). COG has large reserves of gas in the Marcellus region - not a subject in this article - and very good ones in the Eagle Ford shale. Pioneer Natural Resources (NYSE:PXD) is a recent buy that is doing well and has excellent oil reserves in the Permian and good gas assets elsewhere. I also have Whiting Petroleum (NYSE:WLL), a company with some of the largest assets in the Bakken. I may have made a mistake selling Oasis Petroleum (NYSE:OAS) and Triangle Petroleum Corp. (NYSEMKT:TPLM) - time will tell. In services, Helmerich & Payne (NYSE:HP) remains a firm favourite that I have yet to buy, and I continue holding beaten-up Pacific Drilling (NYSE:PACD) in the hope that deepwater drilling restarts before it ends up under water. Easily ignored are infrastructure companies, and I "own" MasTec (NYSE:MTZ) and Matrix Service Co. (NASDAQ:MTRX). They will gain nicely when capex spending resumes.

Conclusions

All issues surrounding supply and demand point in one direction for oil prices - UP. I do not like predicting prices, but whereas I earlier thought $50 for WTI by year end would be the light at the end of the oil price tunnel, I now believe $60 is reachable.

This bodes well for my US oil investments and for all those that have survived the price turmoil since mid-2014, if they can continue to keep their heads above water for a few more months. Rising oil prices will also give confidence to banks and other sector financial backers too.

A part of the US manufacturing recession was caused by massive - over $200 billion - capex cutbacks in the sector, and although this will not recover overnight, there will be a manufacturing recovery, and that will have widespread positive effects for other parts of the US economy, including homebuilders. I have LHI Homes (NASDAQ:LGIH), Toll Brothers (NYSE:TOL) and TRI Pointe Homes (NYSE:TPH) in anticipation of that.

My rational optimism needs to be tempered with caution for the irrational. Saudi and Iran hate each other, and Saudi could throw money at increasing production or do other things to damage Iran's prospects and push down prices. But that irrationality could also lead to direct conflict which would push up prices, so for now, I shall stick with my views.

If you sell black gold in May and buy back on St Leger Day, you will need a big risky bet with the bookies to catch up. Rather than rue the day, I would back the black gold horse today.

Disclosure: I am/we are long COG,PXD,WLL, MTZ, MTRX, TRGP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.